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The heavy re-pricing of values in almost every asset class and sector is coming to an end.

  • Thursday, December 1, 2022

The second half of 2022 has been a more challenging period for investment than the first, given the aggressive interest rate rises of the US Federal Reserve and other central banks as inflation topped 10% in many developed countries. Inflation continues to be the dominant force in global finance. The period of massive government stimulus and public spending that saw the world through the Covid pandemic has now created the environment for high inflation.

The loose money years have now been turned on their head with central banks draining liquidity and tightening monetary policy to bare down on inflation. The consequences of high public spending and huge national debts are now hitting consumer confidence and spending with a recession ahead. The cost of living is putting pressure on wages and creating wage demands while business costs are rising so that profits and jobs are under pressure. Higher interest rates will influence mortgage costs and therefore property values.

Despite these fears, the outlook for stock markets has improved since US inflation looks to be now falling. In the past 5 months US CPI has come down from 9.1% in June to 7.7% in October. With falling inflation there is less pressure on the Fed to continue to rise interest rates more than is already expected. For this reason, US 10-year treasury yields have fallen from 4.22% in October to 3.79% in late November. With falling yields comes price stability and investor confidence.

We are living in particularly sensitive times and markets so easily over react to any new announcement which only increases volatility and investor nervousness. However, markets do know about all the bad news. If it is in the press, it is in the price holds true. Prices are generally starting to get better as markets see beyond what is currently expected to be a relatively shallow recession. Sadly, the UK is expected to be worse hit than most equivalent economies.

From the start of 2022 the world leading stock markets have performed quite differently. Please see below the % returns from 1st January to 23rd November 2022

UK FTSE 100 +1.2%
  FTSE 250 -17.4%
Europe EuroStoxx 30 -8.3%
USA S&P 500 -16%
India BSE Sensex +5.5%
Hong Kong Hang Seng -25.1%
Japan Nikkei 225 -2.9

The difference between the FTSE 100 and FTSE 250 is that the FTSE 100 contains large global businesses but the FTSE 250 represents the domestic UK economy and as such has fared much worse this year.

With the expectations of further interest rate rises, inflation pressure and a shallow global recession we have amended our portfolio selections.

We have continued with our hybrid portfolio blend of both active and passive funds that we established in Edition 37. Edition 38 will see a slight rise in the allocation to active funds particularly in the bond section where we feel active oversight may be worthwhile. Performance has over the recent past has been above benchmark and we seek to maintain that advantage for investors.

The decline in US inflation has been a key improvement for our investment outlook. Inflation in the US is expected to be 7.40 % by the end of this year projected to trend around 2% at the end of 2023. The Fed will be pleased that their aggressive 0.75% increase in interest rates over each of the last four FOMC committee meetings has worked. We now expect the Fed to continue to hike but at 0.5% in December and 0.5% in January. They may then stop raising rates and see how the economy responds. Business and households faced with higher borrowing costs will be encouraged by the potential of no more near-term rate rises.

The labour market in the US remains strong with new jobs being taken up at the rate of 261,000 in October, 315,000 in September and 292,000 in August. The expectation is for around 250,000 new jobs will be filled each month in 2022 but fall to a new monthly target of 170,000 in 2023.

If the number of new job vacancies starts to fall then the Fed will be further encouraged that the US economy is slowing and that their interest rate rises have done their job. We expect another 1% increase in US interest rates as they will want to be sure inflation is beaten. If there are any signs of inflation raising then the Fed will take further action on rates.

We are happy to maintain our overweight position in the US as we do not expect a recession and that the US will recover first and fastest of the developed world. We have an emphasis towards low-cost US index trackers and active value funds with HSBC American Index Trust and Threadneedle US Equity Income Fund held in the portfolio.

We are concerned about the outlook for the UK due to labour shortages and high inflation. The UK’s trade position is weakened and holding back investment and growth. With UK inflation at 11.1%, the BoE are expected to rise interest rates from the current 3% up to 4.5% over the near term in order to combat inflation. However, the Bank is sensitive to the impact that interest rate hikes will have upon borrowing costs, mortgage costs, and consumer confidence. Due to these concerns the BoE has hinted it will not likely go higher than 4.5%.

The UK is expected to enter a recession but perhaps not as severe as Andrew Bailey has predicted. Never the less, we have trimmed our UK exposure and invested in low-cost HSBC FTSE 100 and Vanguard FTSE All share index trackers. In doing so we are holding large UK based international businesses.

We see an improving outlook for continental Europe due to a few factors, not least the success of the Ukrainian army in pushing back Russian forces in the Black Sea and South Eastern regions under Russian occupation. The conflict may endure for many more months and could at any time take a desperate turn but the success of Ukraine should be supported as potentially the quickest way to a settlement.

European gas storage is now full and with alternative sources of LNG from the US and gas from Algeria and Norway, the threat from the Kremlin to cut off Europe’s energy source has weakened. This was Russia’s main play for the West to buckle but has been neutralised in a material way. Energy prices are still elevated but demand looks to be less as so far, the weather has been mild. A mild winter will likely mean that black outs or gas rationing are unlikely and European stock markets have responded positively.

Just like the BoE we expect the ECB not to go hard on rate hikes in fear of crashing the economy. With an outlook of lower-than-expected rate rises and sufficient energy to see the winter through, Europe is looking more attractive. We therefore have marginally increased our holdings in BlackRock European Index.

China has had a major impact upon global growth and inflation. China has adopted an aggressive zero covid lockdown policy which is still in force and has had a major impact upon manufacturing exports and supply. The lack of production has led to increased demand resulting in global inflation. President Xi Jinping has been confirmed in office for a further five years and has announced he will maintain the zero covid policy. Critics see this policy as unsustainable with urban unemployment at 6% and rising as it will disadvantage China. Some analysts are suggesting that a controlled easing of isolation rules and lock downs will start along with further vaccinations. If this is forthcoming then a stimulus programme of investment could follow and get China growing again. For this reason, we have, despite this year’s losses in Chinese equities, maintained our modest holdings in the FSSA Greater China Growth Fund and to the JP Morgan Emerging Markets Income Fund that also invests in China.

The progress of Japan and the Asia Pacific region has been influenced by China’s lockdowns. The reduction in trading has had in impact on stock values in the region. Again, we are expecting improvements in outlook so have retained our holdings in Vanguard Pacific Index Trust and Fidelity Japan Index and introduced Jupiter Asian Income Fund.

The fixed interest market has been exceptionally challenged this year. After years of falling bond yields and elevated prices, we can now see what impact of rising inflation and interest rates have had on the bond market. Inflation and rate rises have forced bond yields to rise significantly and as a result prices have fallen heavily. This year has been the payback year for decades of low interest rates and overpriced bonds.

The UK Conventional gilt index has over the past twelve months suffered a loss of -20.36% as yields have risen to meet market expectations. These are the type of losses sometimes seen in speculative private equity holdings not UK government gilts.

We have not held any long-dated bonds in our portfolio for some editions now so our portfolios have not been exposed to these types of losses. We do hold a blend of short dated, inflation linked bonds along with some hedged bonds and floating rate notes. The short-dated inflation linked bonds and short dated high yield bonds have fallen by around -5% over the past year, while the hedged bond fund is down -1.5% and floating rate note down -2.5%.

We have a more positive outlook for bonds now that it looks like yields will stabilise. US 10-year Treasury yields are now 3.79% down from a high of 4.22% in October. UK 10-year gilt yields are now 3.1% having fallen from a high of 4.45% in October.

Within Edition 38 we have moved from holding inflation liked bonds to conventional bonds. We have continued to select short dated credit but also introduced some strategically managed bond funds in the form of the Jupiter Merian Global Strategic Bong, the Dodge and Cox Global Bond Fund and maintained the Royal London Diversified Asset Backed Securities Fund and M&G Global Floating Rate High Yield Fund. Our actively managed bond funds have increased in allocation as we feel that some active bond management is beneficial at present.

As far as the specialist sectors are concerned, we have been happy to maintain our holdings in sectors that have done well. The Polar Capital Global Insurance Fund has been particularly strong with a one-year return of 23.83%. We have retained Guinness Sustainable Energy Fund but have also added the Gravis Clean Energy Income Fund. The Clearbridge Infrastructure Fund has been replaced by M&G Global Listed Infrastructure on cost and trading grounds. We have halved our iShares Global Property Securities Index Fund holdings as we feel that higher borrowing and mortgage costs will impact property values. We have maintained our holdings in the JP Morgan Natural Resources Fund that has enjoyed on the back of energy and commodity prices a 39.58% return over the past 12 months.

We held in Edition 37, the Polar Capital Technology Fund, T. Rowe Price US Large Cap Fund and L&G Global 100 Index Fund but all three have not been included in this new Edition. We remain concerned about some aspects of the Tech sector and the Mega Tech sector in general. Our emphasis in Edition 38 is value not growth stock as we consolidate.

We are not holding any gold in the portfolio other than that held within the JP Morgan Natural Resources Fund.

We feel that a year of heavy re-pricing of values in almost every asset class and sector is coming to an end and while a recession can bring further sensitive volatility, we can be at last more confident about bond yields stabilising and an improving environment for investors.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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